Capital Employed is the total amount of investment made for running the business. It should not be confused with the term “Capital”. “Capital” represents funds contributed by the owner (s) in a business, whereas “Capital Employed” has a wider meaning. It includes funds coming from both the owners and lenders, i.e., it covers both equity and debt.
There is no universal definition of the term “Capital Employed”. However, the general intuition is that it is the investment made in a business for earning profits. In one sense, it reflects the total funds put to use (i.e. “employed”) for running the show. In other words, it is the value of assets that provide the business its ability to earn revenues. More technically, it is the amount of capital utilized for acquisition of Profits or Assets.
Different accountants compute it differently. Capital Employed can be computed using either the asset side or the liabilities side of the balance sheet. Both the approaches are illustrated with the help of an example.
First Method: Using the Asset Side of the Balance Sheet
In this method, we include:
- All the fixed assets at their net values after accounting for depreciation. In an inflationary scenario, the replacement cost of these assets should be used as it reflects their current market value better.
- All investments made in the business.
- All current assets viz. Sundry Debtors, Cash, Bank, Bills Receivable and Stock etc.
Importantly, only business assets are considered. That means although we do take into account the intangible assets like goodwill, patents, and trademarks; fictitious assets are not taken into account.
Finally, current liabilities are subtracted from the above to obtain Capital Employed.
Let us make our concepts concrete with an example. Consider the following balance sheet:
|I. Equity and Liabilities|
|1. Shareholder’s Funds|
|a) Share Capital||400000|
|b) Reserves and Surplus||100000|
|2. Non-Current Liabilities|
|Long Term Borrowings||150000|
|1. Non-Current Assets|
|a) Fixed Assets||400000|
|b) Non-current Investments||100000|
|2. Current Assets||200000|
Here, using the method described, the amount of capital employed will be:
Fixed Assets + Non-current Investments + Current Assets – Current Liabilities
= 650000[adsense float=”right”]
Second Method: Using the Liabilities Side of the Balance Sheet
Alternatively, we can compute the capital employed by using the liabilities side of the balance sheet. We proceed as follows:
- Include Share capital (Equity + Preference)
- Include Reserves and Surplus (e.g. General reserve, Capital reserve, Profit & Loss account etc.).
- Include Long-Term Borrowings like Debentures and other loans.
Going back to our example balance sheet and using this approach, we evaluate the Capital Employed as:
Share Capital + Reserves and Surplus + Long-Term Borrowings
As mentioned earlier, in the absence of a universally accepted definition of Capital Employed, a few other approaches for computation of Capital Employed may be found, e.g.
- Sum total of all assets fixed or current (Gross Capital Employed)
- Sum total of fixed assets (Net Capital Employed)
So, why is capital employed computed at all? Since it is a measure of resources (financial inputs) committed to a business, it is used to assess overall profitability (output). This is done by computing “Return on Capital Employed (ROCE)” or “Return on Investment (ROI)”:
In this formulation of ROCE, sometimes use of ‘Average Capital Employed’ is preferred over just ‘Capital Employed’. What is Average Capital Employed? It is an average of the capital employed at the beginning and at the end of the accounting period.
Another use of Capital Employed is that it is a measure of the size of the business. Regulators use it to classify businesses into small, medium or big.1,2